Question

Consider arbitrage between interest-bearing assets. What is the difference between using a forward contract and not using a forward contract? Which is risky and which is not? What are the parity conditions of the two different approaches named?

Answer 1

Forward contracts are tailormade contracts that means they can be constructed keepinng requirements of counterprties in mind.

Forward contracts doesnt involve any third party into this contract.

Not using forward contract can be understood in two different ways such that 1) Keeping position open that is unhedged & 2) Buying future contracts or exchange traded hedging instruments.

In Forward contracts as there is no third party involved therefore couterparty risk is seen in such contracts becuase any of the counterparties can turn down the contract in unfavourable future states.

In Future or exchage traded instruments third party plays a vital role to eliminate the counterparty risk

When there is an arbotrage opportunity present one can buy low and sell high the same asset in two different or the same market.

If arbtirage is present then there is no chance of risk hence using forward or any hedging instrument is not good idea.

Arbitrage opprotunity can be eliminated with the form known as Law of One Price (LOOP)